WHAT ROLE HAVE BANKS IN FINANCIAL CRISES?

Alin Marius ANDRIE*

Abstract: Financial crises mainly manifest themselves at the level of

financial institutions. Although financial crises can also be generated
within non-financial institutions, the role of banking institutions in the
occurrence, transmitting and solving of financial crises is a deciding
one. Banks play a deciding role in the development of financial crises
as financial intermediaries who contribute to the efficient transfer of
funds from the abundant agent towards the deficit agents. Banks can
facilitate the financial crises through the activities performed on the
financial markets that can influence the interest rates, the uncertainty
on the market and the price of assets, but moreover bank crises can
occur that transform financial crises.
This paper aims to analyze the role of banks in the emergence, the
propagation, the prevention or solving financial crises.
Keywords: financial crises, bank crises, contagion
JEL Classification: G01, G21

1. INTRODUCTION
The development of financial innovations and risky speculations, the
expansion of loans, the increase of the prices of assets without any economic basis,
the sudden and unexpected decrease of the prices of financial assets and the quick
orientation towards liquidities or quality investments are unavoidable as long as
investors follow the obtainment of as large as possible profits. Under these
circumstances, the emergence of the financial crisis is not a novelty, but, as a
defining trait of it, the global financial environment enables the possibility of
transmitting the crises in the entire system, respectively their contagion.
Bank crises, as special forms of manifestation of financial crises, are known
for a long time. No mater the type of financial system (market-based or bank-based)
or the degree of development of the financial system (very developed, market

Alexandru Ioan Cuza University of Iasi, andries.alin@uaic.ro

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functional, developing or emerging), bank crises have marked most of the states of
the world.
The vulnerability of the banking system must be sought in the very essence of
the basic banking activity the granting of loans based on attracted deposits. The
system is functional as ling as the banks keep, in liquid form or in investments with
a high degree of liquidity, a part of the attracted deposits in order to be able to
handle the withdrawal requests coming from the deponents. If at some point most of
the banks clients would request the withdrawal of savings, the bank could be on the
end up of bankruptcy. Because of the special characteristics of the banking activity,
the bankruptcy of a bank is similar to the unbalancing of a domino piece that attracts
with it the crashing of the entire system. That is why, the prevention or solving of
the bank crisis, in its first stages, is a necessity acknowledged by authorities and
highlighted by their massive degree of involvement in solving crisis situations.

2. DEFINITION AND CLASSIFICATION

The term financial crisis was explained by considering numerous aspects,
such as the causes, evolution and impact of this phenomenon. According to EFC
(2001), the financial crisis is any situation in which a financial institution, or a
number of financial institutions, is in incapacity of fulfilling its statutory obligations,
a situation which negatively affect the functionality of the entire financial system.
According to Kaminsky and Reinhart (1999) financial crises can be defines
depending on the forms they manifest themselves in: currency crises, bank crises
and twin crises. In the case of currency crises, the attacks, internal or external, on
a currency produce important reductions of the currency reserves, substantial and
acute depreciations of the currency exchange rate of combined effects of these. Bank
crises are generated by a series of micro and macroeconomic factors, and the forms
they take vary from declaring bankruptcy, merger or overtaking by the public sector
by nationalizing a bank, a group of banks or the entire banking system. Twin crises
are a combination of the currency crises with the bank ones.
In the literature in the field financial crises are analyzed in a temporal
approach and it makes the distinction between I, II and II generation crises. The I
generation crises are specific to the 80s and they take on the classic form of the
balance of payment crisis and of the budgetary deficit financed through internal loan
ad are considered to be generated from the inside. The crises in this generation are
specific to small economies with fixed exchange rates and that have liberalized the
capital account, being, for these reasons, sensitive to speculative attacks that could
easily degenerate into currency crises.
The second generation of financial crises stems from the speculative attacks
on the currencies in the European Monetary System in the years 1992-1993 and
from the Mexican crisis in the years 1994-1995. The possibility of occurrence of the

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financial crises even in an economically stable environment was illustrated, these

crises being considered as self-generating. The model presented in this category is a
edited one, having three major participants: the government that is the position to
defend the exchange rate of the national currency or to change the exchange rate
system depending on the compared benefits of these actions and two speculators in
the respective currency, who havent got the necessary resources to exhaust the
government reserves though.
The crises in the third generation of financial crises are much more
heterogeneous than in the other two cases, being related to the problems generated
by the balance sheet exposures and presenting three big options: the impact of the
moral hazard on the crediting process, the reciprocal impact of the currency and
bank crisis, the implications of the currency depreciation on the balance of
payments.
Most of the recent financial crises are crises in the latter generation, which
stem inside the financial sector and are related to structural dynamics such as the
financial innovation.
The models in the third generation present different mechanisms, all related to
incongruencies within the financial balance sheet, incongruencies that can take,
according to Dianu and Lungu (2008, p. 7) one of the following shapes: a) the
incongruence of maturities, occurs when the differences between the short term
debits and liquid assets lead to the inability of the institution to pay its current debts,
on the background of the refusal of creditors to extend the crediting contracts and of
the unfavorable influence of the increase of interest rates; b) the incongruence in
currencies can provoke capital loses when sudden changes of the exchange rates
occur; c) the problems related to the structure of capital under the circumstance
when a high degree of indebtness exposes the institution to uncertainty and shocks
provoked by the adverse reaction of the markets; d) the solvency problems when the
institution is incapable of covering its debits with assets; the problem of an
inadequate solvency occurs on the background of a low degree of long term
liquidity.

3. THE ROLE OF BANKS IN THE PROPAGATION OF FINANCIAL CRISES

Financial crises mainly manifest themselves at the level of financial
institutions. These institutions can be banking institutions, insurance companies,
investment companies, financial intermediation companies or financial
conglomerates. Although financial crises can also be generated within non-financial
institutions, the role of banking institutions in the occurrence, transmitting and
solving of financial crises is a deciding one.
The important role of banks in the propagation of financial crises is explained
through a series of arguments, that is: the difference between the maturity, due-date

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of the elements of assets (placements) and liabilities (attracted sources) from the
bank balance sheet; the prominent role of banks within the payment systems and
especially within compensating ones, in many cases the banks being founding
members of the clearing houses; the substantial exposures that the banking
institutions have on the interbank, internal and international markets; the banks have
become in the past decades important participants on the capital markets, achieving
thus a connection bridge between the different components of the financial system.
Banks play a deciding role in the development of financial crises as financial
intermediaries who contribute to the efficient transfer of funds from the abundant
agent towards the deficit agents. Banks can facilitate the financial crises through the
activities performed on the financial markets that can influence the interest rates, the
uncertainty on the market and the price of assets, but moreover bank crises can occur
that transform financial crises. Bank crises can be defines according to Allen and
Gale (2007) as being a financial period difficult enough to lead to the erosion of
most or of the entire capital in the banking system.
Financial crises are characterized by an accentuated decrease of the prices of
assets, the bankruptcy of some major financial and non-financial institutions,
dysfunctions on the currency markets, according to Mishkin (2001) the factors that
can determine the occurrence of a financial crisis can be: 1) deterioration of the
balance sheet situation of financial institutions, 2) increase of the interest rate, 3)
increase of the uncertainty in economy and 4) deterioration of the balance sheet
situation of the non-financial institution because of the volatility of the prices of
assets.
Allen and Gale (2001) showed that the occurrence of the crises is not
conditioned by the structure of the financial systems, crises can occur in any type of
financial system. Te occurrence of bank crises depends more on the development
level of the financial system or of economy. Kaminsky and Reinhart (1999) showed
that most times bank crises were preceded by an excessive exposure of banks on the
stock and real estate market. According to Demirgc-Kunt and Detragiache (1998)
the occurrence of bank crises is facilitated by the financial liberalization process
corroborated with an inefficient laws system and with a high degree of corruption.
The key role the low quality of the bank management had in the occurrence of
crises was showed by numerous studies. Dziobek and Pazarbasioglu (1997)
established that the deficiencies in the bank management and control, together with
other factors, were causes in all 24 studied systemic bank crises. In another study,
concentrated on a sample of 29 insolvable banks Caprio and Klingebiel (1996)
concluded that responsible for the occurrence of these phenomenons is a
combination of macro and microeconomic factors. Te macroeconomic factors are
represented by the recession situation, while, on a microeconomic level, an

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important role have the low quality of bank supervision and regulation and bank
management deficiencies.
The imbalances on the level of the entire bank system are closely connected to
the macroeconomic factors, which can be cyclical (economic recession) or structural
(low quality of bank supervision and regulation)).
The macroeconomic instability has permanently constituted an important
factor generating systemic bank crises. The existence of stable macroeconomic
conditions, mainly the stability of prices, is a mandatory requirement of financial
stability, in general and of the banking one, in particular. The expansionist monetary
and fiscal policies can determine a sudden increase of the crediting activity and of
the price of assets, as well as of the accumulation of debits. Because these policies
can not be sustained on the long term, their correction determines the decrease of the
economic growth, the decrease of the price of assets, problems with the debt service
and, finally, the inability to pay debtors which will have a negative impact on the
financial situation of the banking system. The external macroeconomic conditions,
such as adverse changes of the exchange rates in relation to the contractual clauses,
contribute to the occurrence of bank crises.
The structural evolutions can constitute an additional important factor in
explaining bank crises. The existence of a coherent legal system and of a robust
supervision structure is a precondition of a stable banking system. The liberalization
of the aces conditions on the local banking markets determines the intensification of
competition and the threatening of the positions of the institutions existing on the
market up to that date. Financial innovations can have a negative effect in the
circumstance when the quick growth of a new product is not sustained by a thorough
knowledge of its management method (the case of derivative financial products).
According to Rochet (2008, p. 23) the baking system is functional for as ling
as banks keep in liquid form or in the form of investments with a high degree of
liquidity a part of the attracted deposits in order to be able to handle the withdrawal
requests coming from deponents. Precisely for this cause, the baking system is
considered fragile. If at some point, from various reasons, all deponents of a bank
would request to withdraw their savings, situation known as bank run, the bank
has to liquidate all its assets, including long term placements, situation that provokes
the bankruptcy of that institution.
The causes at the base of the bank run phenomenon are of objective or
subjective nature. The former are part of a selection and elimination mechanism of
non-competitive institutions. In this case, the withdrawal of deposits is based on
information on the doubtful quality of bank assets owed to inefficient investments.
The literature in field calls this phenomenon fundamental run, because the actions
are based on rational comparison elements.

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The subjective causes that can determine the occurrence of the bank run
phenomenon comprise speculative factors. These factors have a negative impact on
the functionality of the bank institution. The speculative run is generated by the
herd phenomenon, in the sense that if a deponent anticipates hat the other
deponents will withdraw their savings in mass will withdraw his/her savings even if
they own information according to which the bank is solid from a financial point of
view.
In order to solve these crises situations with a profound impact in he entire
banking system as effectively as possible a series of mechanisms were conceived
and implemented, such as the institution of the last instance creditor, the bank
deposits insurance system, public interventions through capital infusions or the bank
supervision rules (Rochet 2008, p. 24).
These mechanisms were conceived to be implemented in order to avoid
extreme bank crisis situations, such as systemic crises. Because of the essential role
of bank institutions within economy, of the fragile character of the banking activity
and of the globalization process with implications on the free movement of capital,
he bankruptcy of a bank is seen as an event with an impact with multiple
connotations that can give an alarm signal on the solvency of the other banks in the
system, being able to finally start a systemic bank crisis.
A systemic crisis may develop either as a result of a macroeconomic shock or
as a result of contagion (Freixas and Rochet, 2008, p. 235). Systemic bank crises
can be generated according to Dornbusch and Giavazzi (2001) by three causes that
can occur wither separately, or combined, in this later situation a nightmare
scenario resulting. The first possible cause of the systemic crisis is represented by
the poor management of the crediting risk, a phenomenon known in the literature as
directional crediting. In this case, the financing offered by banks is not founded on
profitability and the covering of risks. This situation occurs when banks are used as
instruments in the implementation of economic-fiscal policies within the
development strategies or when the high level of the interest rates is used as
instrument for the increase of the saving degree and, in this case, the active interests
are compressed to satisfy preferential debtors.
The second scenario is that in which an operational banking system is affected
by strong macroeconomic shocks. If the cost of the financing of banks suddenly
increases on the background of the existence of some fixed interest rates for loans,
the banks must support the emergence of loses and are forced by the financial deintermediation process to accept costly financings with short term due dates. If this
situation is prolonged in time, banks get to be decapitalized the same effect is
produced in the case of the severe and long lasting recession period that affects the
quality of the credit portfolio, the spread no longer being able to cove the loses
generated by subprime loans. Also, there is the possibility that the banking system is

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affected by currency crises. In this situation, the banks debtors, who have borrowed
in other currencies or have commercial contracts denominated in other currencies,
suffer massive capital losses because of the currency shock, propagating this
phenomenon within banks by decreasing the quality of the credit portfolio. On the
other hand, the banks that contracted loans on the interbank markets or external
capital loans, without making an adequate hedging for these positions, will be
decapitalized because of the impact of the currency crisis.
The third scenario emerges on the background of the banking liberalization
measures, measures unsupported through an adequate prudential supervision. The
initial image is that of an oligopoly type banking system, protected by the
competition both by foreign banks, which have no access on the market, as well as
by non-banking financial intermediaries from within the economy. With the started
liberalization process, the newcomers, too little regulated in the incipient stages, will
offer services for low prices because of the low capital costs. The balance sheet of
the banks already existing on the market will deteriorate, the decapitalization of the
banks being performed on the background of the immobilization of assets with
unattractive interest, of the deterioration of the quality of the portfolio by losing the
best clients, of the increase of the financing cost.
The banking liberalization can also produce another scenario when the new
banking intermediaries orient their activity towards some market niches neglected
up until that moment, such as the mortgage credit. The lo crediting cost, the
insufficient regulation and the lack of banking experience produce in a first stage an
exponential increase of this crediting activity. The soap bubble bursts when the
increase rhythm slows down and the subprime loan quota reaches alarming levels.
This situation is even more severe under the circumstances when the loans were
contracted in other currencies and the devaluing process determines the alarming
increase of the debt service.
The contagion models were developed more recently, after the Asian crisis in
97, which proved, more visibly than in the previous cases that, when a country goes
through a financial crisis, at the same time and, especially, in the same area other
countries as well are affected. In the past decades it was proven that a small
amplitude shock can have a significant impact on the financial markets. A initial
shock only affects a certain region or a certain sector or even only certain financial
institutions and can be propagated, by contagion, through the connections between
banks and other financial institutions towards the entire financial system or towards
other regions.
The analysis of the contagion effect can be performed based on the direct
connections between banks, by studying how the banking system reacts to the
impact of a crisis when the banks are integrated in a certain network. In a banking
system where the clients have a certain preference for liquidity, banks ensue

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themselves against the liquidity shocks with the help of loans on the interbank
market. The relationship developed between banks through the swap contracts
exposes the entire system in case a liquidity shock occurs at the level of a
participant. The weakly developed banking systems are more exposed to the
contagion effects than the developed systems because in these developed systems
the relationships between banks are more developed and thus a larger percentage of
the portfolio losses suffered by a bank are transferred to several banks through the
interbank contracts.
An interest theme is represented by the analysis of the impact of the
individual risk of a bank on the entire banking system. Freixas, Parigi and Rochet
(2000) analyzed the case when a bank must handle a liquidity shock and the
connection between the banking institutions is performed through interbank credit
lines. The impact of such a shock depends on the systems ability to handle a
regional liquidity shock. Allen and Gale (2001) analyzed the impact of bankruptcy
of a bank on the entire banking system and showed that the more developed the
interbank connections the les the impact of a bankruptcy on the entire system.
According to Allen and Carletti (2006) in the analysis of the role of banks in
the contagion of financial crises the financial innovations and the used accounting
system must also be considered.

4. A SOLUTION FOR BANKING CRISES

Rojas-Suarez (2004) elaborated three basic principles in conceiving a
successful program for solving banking crises. The first principle consists of the fact
that the society on the whole must exercise a strong political pressure so that the
solving of the bank crisis becomes a priority for the authorities, and the solving is
made by allocating non-inflationist public resources. The second principle consists
of the fact that the parties who obtained substantial benefits from the risky banking
activities must pay a large part of the cost of banking restructuring. The third
principle is represented by the emergency implementing of the measures through
which problem institutions are forbidden to continue granting loans to debtors with a
high degree of risk or the capitalization of arrear interests by granting new loans.
Different mechanisms were conceived for the solving of bank crises,
measures were implemented having as purpose the decrease of the level of costs and
strategies were adopted depending on the type of the bank crisis. From these, the
most important ones are: the institution of the last instance creditor, the insurance
system of bank deposits and the prudential baking supervision regulations.
The institution of the last instance creditor consists of the support offered by
the central bank, in the shape of liquidities, to the affected banking institution.
According to Freixas and Rochet (2008, p. 243), who takes the theory formulated by
the English economist Walter Bagehot in 1873, in order to have the desired effect

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thus mechanism must respect the following principles: a) to grant loans to the
institutions confronted with problems only based in some quality warranties, so that
only solvable banks have access to this type of loan and the central banks is
protected by the possible losses; b) to only grant loans to very high interest rates, so
that only truly un-liquid banks will borrow, and the other situations of lack of
liquidity, that present no problems, are solved by the market; c) to announce in
advance its availability to offer this type of financial support, thus obtaining
credibility.
Through the insurance system of bank deposits, banks, based on a percentage
contribution from the total of the attracted deposits, are insured that in case of the
occurrence of the bank run phenomenon, they will reimburse each client with a limit
amount established through the statute.
Studies performed by the International Monetary Fund showed that the
countries that adopted this bank deposits warranty system are much more exposed to
the occurrence of bank crises than the ones that have no such system. The
explanation, fro this perspective, is that in the presence of such a system banks
assume excessive risks more easily knowing that the deposits are insured in cases of
bankruptcy.
The strengthening of the bank supervision, with an accent on the solvency
requirements, emerged as a reaction to the bank crises. They were internationalized
by the publishing by the Basel Bank Supervision Committee in 1988 of the
minimum capital requirements and of the solvency level of 8%. These regulations
were updated and perfected through the new Basel Agreement II. The importance of
the level of the degree of solvency is explained by a) the role of equity for
supporting the activity and the losses in crises situations and b) through the cointeresting of shareholders to monitor more carefully the bank management in order
to avoid large losses caused by bank crises.
The national financial and banking systems present particularities and that is
why the reactions to the occurrence of bank crises are different. Nevertheless, the
strategies used in the case of crises have common elements and refer to the measures
applied for the decrease of the level of costs on economy and tax payers, to the
limiting of the impact of future moral hazard.
The solutions applied by the private sector, in the detriment of the public one,
are considered to be the most indicated for solving the bank crises. If, in the case of
a bank found in state of bankruptcy, the supervision authority imposes to
shareholders or creditors to recapitalize the bank, this solution is viable because it
allows the institution to function, and to shareholders to get involved in the
restructuring of the institution. The case of the takeover of the bank found in crisis
by another bank can be seen as a penalty measure for incompetent management.

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In practice, there is a wide range of options for solving the bank crises. In one
extreme is the keeping of the bank operational by injecting capital from the
shareholders and, at the other extreme, the shutting down of the bank by selling
assets, compensating deponents and the potential payment of creditors. Between
these two extremes, the license of the bank can be suspended, and it is sols, entirely
or partially, to another institution to preserve the banking activity. Between these
measures the involvement of authorities also varies. The involvement can be limited
to encouraging or organizing the private sector or can be extended to offering
financial support and, in extreme cases, to nationalization measures.
The first solution in solving a bank crisis is to involve the private sector, for
the reasons mentioned above in case that this support can not be obtained, there will
be decided between the solution of liquidating the affected bank and involving the
authorities. Under exceptional circumstances, when the bank crises is expected to be
a systemic one, the authorities can adopt some intermediary measures such as
nationalization or warranty for the bank found in bankruptcy.
Certainly the theories regarding bank crises and financial crises will know
extended developments because of the current global financial crisis started in 2007.
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